The Debit Spread: Explained in Detail
The poor man’s covered call.
A debit spread.
Bull call spread.
These can mean the exact same thing for the most part.
Let me walk you through some really important aspects of the bull call spread and give you as much useful, valuable and enriching content as I can in this one article.
What is a debit spread?
Debit = You are spending money. Which means, these trades DO NOT require margin.
Which is nifty since if you trade in an IRA and can’t trade on margin.
Spread = Two different strikes of an option in the SAME direction.
What I will do below is show you what a debit spread looks like on an active trade. I’ll show you what it looks like on the chart and then I’ll explain it graphically. Honestly, this article will probably become one of your favorites!
The $220 call is the long call option. Which is the one I bought. The $260 is the short call option. Which is the one I sold.
Picture below of a debit spread on an option chain:
Picture above of a debit spread on a positions tab. [I'll explain this position more later, but I sold the option a few months after being in the long call.]
To clarify, the + sign means I bought it. The - sign means I sold it. The $2,585 is the total PNL on this trade. The $272.50 is the daily PNL.
Let me explain the WHY behind this trade.
First, we need to time travel back to June 4th, 2019 so you can see the EXACT moment when I became unwaveringly bullish on NVDA.
LISTEN TO THE ABOVE. Please. I do call outs like this ALL THE TIME.
Second, at this point I am confident you know if you are bullish on a stock you can either buy shares of the company or buy a call option.
Therefore, if you buy a call option on a stock, any call option that means you are bullish on the stock and you want it to go up. If you want to reduce the cost of the purchased option, you can sell an option against it. Again, you do not need margin to do this trade. However, your broker might still require you to have extensive option knowledge before approving you of debit spreads. But there can be a pretty cool benefit. Let me give you an example.
When I bought the option on NVDA, I paid around $4.00 per option contract. That’s $400. $400 total purchase price. WORST case, I lose $400 per contract. If one is bought, $400, if 10 are bought $4,000 and if 100 are bought $40,000.
I’m glad to know you are still with me. Now, in June of 2019, NVDA was trading around $145. When NVDA bounced up into $200, I started making SIZEABLE… like… new house money on this trade. The option, which was originally $4.00 per contract was now trading at $15!!! So, I sold some options against my calls. I sold the $260 calls, which was above my strike. This part is important.
The option that I sold, the $260 call, brought me in $6.00. Now, if you have your calculator, I originally bought the contracts which cost $4.00. But I sold an option for $6.00. Therefore, the NET CREDIT on this trade was actually $2.00. Meaning, literally worst case scenario on this trade, I’m going to make $200 per contract.
Granted, this was an exceptional example, but you are getting excited right?
The point of debit spreads is to either:
reduce the cost of your original purchase upfront or reduce the cost of your original purchase price later.
It’s kind of up to you. I generally do the latter portion. I RARELY, which is almost never, buy a call option while simultaneously sell a call option against it, creating a bull call spread upfront. Because if I’m buying a call option, I’m REALLY bullish on something, meaning I am expecting a hellacious strong bull move. Why cap the upside immediately, right?
How about we review some more examples together.
Ticker SPCE: I’m really bullish on this one right? Expecting some strong upside in the future.
Therefore, I could buy the January 2022 $20 call option for $8 per contract and spend $800 per contract approximately.
If you buy 10 contracts, your total investment is only $8,000. From here, you could turn it into a debit spread by selling options against it. This is also known as a poor man’s covered call.
If you sell THE EXACT same expiration, January 2022, then it becomes a classic bull call debit spread.
Selling the $35 January 2022 call option would bring in $5.00. So, the TOTAL cost for this trade, would be $8.00 - $5.00 = $3.00 per contract.
Your risk therefore is $3 and your potential gain is the difference between 35 (the sold strike) - 20 (the long strike) - 3 (your cost) = $12.
Risking $300 per contract to potentially make $1200 per contract. That’s a 1:4 risk reward ratio and you have almost 2 years for this trade to work out.
Pretty saucy! What’s the risks on this trade? Like I said, not much. Only $300 total per contract. You have two years for SPCE to sky-rocket.
Now, you could also JUST buy the $20 leap call and do nothing. You could wait. AND IF SPCE goes up to $25 or so, in the next few weeks, then you could sell an option against it.
If you own a January 2022 $20 call option and sell any other expiration it then becomes a calendar spread. And the “dangers” of this is if at expiration the stock closes above your short call and it has a different expiration than your long call, your broker will sell shares short at that price. Still following? Say trader Frank owns the 2-year call option and sells the April 2020 $26 call option, he would reduce his $8.00 purchase price by $1.60. Therefore, he would only need to sell 4 of those to PAY FOR his long call. By this time next year, he could have a TOTALLY FREE LEAP OPTION ON SPCE! YES, I’m screaming! How amazing is that?!
The only downside is come the 3rd Friday in April if SPCE closes above $26, which is likely, he would have to EITHER buy to close the sold 26 call option OR close the whole position.
Personally, I generally sell the same expiration. I don’t want to fool with the different expirations, tweaking, rolling, adjusting. It can be a lot of work and sometimes it’s unprofitable. Because a shorter-term option can lose money faster than the longer-term option. In this situation if trader Frank bought the January 2022 $20 call option and then sold the April $26 call, if SPCE is at $35 by April, likely, then his $20 call would be SUPER PROFITABLE. But the short $26 call would be super-duper unprofitable. And the whole trade could be losing even though it shouldn’t be, due to implied volatility or something else kind of wild.
Here are some traders who took advantage of my bullishness on SPCE already!
Therefore, that’s how I personally do it. I prefer buying a longer-term call option. One with more than 9 months to expiration. I hold it for 2-3 months. DID the trade work? If it is, I hold until the option triples in value. Then I sell the same expiration NICE AND FAR away and then… I let it ride.
My intention was to avoid a 10,000 word article on this process. You know me… I can ramble on for hours about this stuff. So, let me give you three charts below to give you visual detail on some of these trades and then you can paste any questions you have below!
Thank you for taking this mental journey with me! If you have any questions or need anything else from me, please let me know.
~ Jerremy Alexander Newsome
CEO and current ping pong champion of RLT